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In U.S. energy boom, a growing tax dodge

May 28, 2013: 9:19 AM ET

More energy companies are converting to a tax-free status that was once reserved for a small segment of the industry.

130524140354-natural-gas-drill-fracking-614xaFORTUNE -- More and more of the companies benefiting from new technologies that are fueling America's recent energy boom are paying little or no taxes.

In early May, Emerge Energy Services sold $127 million in shares in an initial public offering. Emerge (EMES) supplies sand to oil and gas drillers for blasting through rocks in the hydraulic fracturing process. The company says demand for frac sand has risen nearly 1,600% in the past decade, according to the IPO documents. It expects demand to double again in the next decade.

Sales at Emerge, which provides various services to energy companies, have more than tripled in the past two years to nearly $1 billion in 2012. It earned just over $27 million last year. Nonetheless, Emerge, which is structured as a master limited partnership, paid just $160,000 in overall taxes, for a rate of 0.5%, and none of that went to the federal government.

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"The IRS has been very generous to these companies," says Willard Taylor, a corporate tax lawyer at Sullivan and Cromwell. "Absent a change, the number of companies looking to take advantage of this tax status will continue to grow."

So-called master limited partnerships were created in their current form in 1987. The corporate tax exemption is available for passive companies that pay out nearly all of their income to shareholders, who then pay taxes -- generally real estate or investment firms.

But the law also extended the tax-free status to certain types of oil and gas companies. For a long time, the MLP structure was primarily used by the transport companies. U.S. pipeline owners argued that the tax break allowed them to attract investors to a low-growth, but vital, portion of the nation's energy infrastructure.

Recently, though, a growing variety of energy companies have been seeking out the tax-free status, many of which are not low-growth or lacking investment. Of the seven energy companies that have IPOed this year as MLPs, only one was in the pipeline business. In addition to Emerge, there was an oil refiner, a coal miner, and a shipping company. In all, 40 MLPs have issued stock this year in either IPOs or follow-on offerings, raising $11.2 billion, up from 27 companies raising nearly $8 billion in the same time last year.

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In part, the growth of MLPs is just another by-product of the Federal Reserve's strategy to revive the economy. Low interest rates have boosted the demand for all high-dividend paying stocks. MLP shares, which have an average dividend yield of 5.7%, are up 23% through May, according to the Alerian MLP index.

But at the same time, the emergence of fracking has almost overnight made once sleepy corners of the energy business, like pipeline MLPs, into growth machines. A number of economists point to America's growing energy supply production as a reason the U.S. will pull out of its current rut. The boldest of calls is that low-energy prices will lead to a manufacturing renaissance in the U.S.

But at a time when many are worried about the national debt, and when there is increased scrutiny on whether companies are paying their fair share of taxes, it's worth noting that an increasing number of companies participating in this boom don't pay corporate taxes. There is now $400 billion invested in publicly traded MLPs, up from $40 billion a decade ago.

And the number of companies eligible for the status could soon grow dramatically. Industry lobbying groups are pushing a bill in Congress that would further extend the MLP-tax-free status to alternative energy companies, which currently don't qualify.

"It's always nice to say we should lower taxes to encourage investment," says Karen Burke, a law professor who specializes in corporate tax structures at the University of Florida. "But at some point the question of overall tax revenue has to be considered."

It's hard to know just how much energy companies avoid paying in taxes by becoming MLPs. Generally MLPs are formed when an energy company spins off assets into separate partnership and then sells a portion of that partnership off to individual investors. But the parent energy company forming the MLP still has to pay taxes on the income it gets from its remaining stake in the MLP. Investors who buy the shares have to pay ordinary income taxes on the dividends they receive from MLPs, higher than the 20% typically paid on investment income or capital gains by wealthy individuals.

Even energy companies that don't convert to MLPs still can take advantage of an array of tax breaks, so they might not end up sending much to Uncle Sam anyway. "The government is not giving up much tax revenue on these structures," says Tim Finn, a lawyer at Latham & Watkins that specializes in MLPs. "The main reason companies form MLPs is so they can sell off these assets and get a higher valuation for them."

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But there most certainly seems to be a tax benefit as well. At the very least, becoming an MLP cuts out a layer of corporate taxation that companies would normally have to pay on that income. And Burke says a growing number of hedge funds and pension funds are making their investments into MLPs through shell companies that allow them to avoid paying some or all of the taxes on their MLP investments. What's more, some energy companies do a follow-on IPO where they turn their remaining ownership stake into another separate MLP, cutting their tax bill further.

MLP critics say the idea that the companies wouldn't pay more if they were typical filers is based on the current tax code. Both sides of the corporate tax debate agree that we need to eliminate deductions in order to lower the overall tax rate companies pay. Cutting out deductions is likely to hit energy companies more than others.

SunCoke, which produces a raw material that is used to fuel blast furnaces that turn iron ore into steel, went public earlier this year as an MLP. According to its offering statements, the company said it paid $10 million in taxes in the first half of 2012, an effective tax rate of 30%. After converting to an MLP, SunCoke (SXC) said it expected its tax bill to drop to zero.

"Why would you let a whole sector get out of paying taxes?" says Burke. "That's going to make it a lot harder to reduce the rate on everyone else."

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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